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Leithner Letter No. 175-178 26 June-26 September 2014

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Leithner Letter No. 175-178 26 June-26 September 2014 Page 1 of 13 Leithner Letter No. 175-178 26 June-26 September 2014 Like many of the best market analysts, Seth Klarman looks at both sides of the issue, the bull and bear case, in depth. “If you’re more focused on downside than upside, if you’re more interested in return of capital than return on capital, if you have any sense of market history, then there’s more than enough to be concerned about,” he wrote [recently]. Citing a policy of near-zero short-term interest rates that con- tinues to distort reality and will have long term consequences, he ominously noted “we can draw no legit- imate conclusions about the Fed’s ability to end QE without severe consequences,” a thought pervasive among many top fund managers. “Fiscal stimulus, in the form of sizable deficits, has propped up the consumer, thereby inflating corporate revenues and earnings. But what is the right multiple to pay on juiced corporate earnings?” As he outlined the bear case, he started to divulge his own analysis that “on almost any metric, the U.S. equity market is historically quite expensive. A sceptic would have to be blind not to see bubbles inflat- ing in junk bond issuance, credit quality, and yields, not to mention the nosebleed stock market valua- tions of fashionable companies like Netflix, Inc. and Tesla Motors Inc.” Comparing the economy and the Federal Reserve’s management of it to the movie The Truman Show, where the lead character lived in a false, highly-orchestrated environment, Seth Klarman notes with in- sight, “Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist is so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they’re sure everyone else won’t stay on forev- er.” Then he quotes Jim Grant who recently noted on CNBC, the problem is that “the Fed can change how things look, it cannot change what things are.” Seth Klarman: Fed Created Truman Show Style Faux Economy ValueWalk (3 March 2014) While the U.S. may be rejoicing its daily stock market all-time highs day after day, it may come as a surprise to many that global equity capitalization has hardly performed as impressively compared to its previous records set in mid-2007. In fact, between the last bubble peak and mid-2013, there has been a $3.86 trillion decline in the value of equities to $53.8 trillion over this six year time period, according to data compiled by Bloomberg. Alas, in a world in which there is no longer even hope for growth without massive debt expansion, there is a cost to keeping global equities stable (and U.S. stocks at record highs): that cost is $30 trillion, or nearly double the GDP of the United States, which is by how much global debt has risen over the same period. Specifically, total global debt has exploded by 40% in just 6 short years from 2007 to 2013, from “only” $70 trillion to over $100 trillion as of mid-2013, according to the [Bank of International Settlements’] just-released quarterly review. Global Debt Exceeds $100 Trillion as Governments Binge, BIS Says Bloomberg (9 March 2014) Page 2 of 13 The Risk of a Mere Correction – Or of a Severe Bear Market? “The Australian share market notched up a fresh near six-year high at [today’s] open,” reported Business Spectator on 24 April 2014. “The S&P-ASX200 now sits at its highest intraday level since the week of June 9, 2008, eclipsing the intraday high of 5,521 set yesterday.” Is this good news or a bad omen? According to Shane Oliver (The Risk of a Correction or New Bear Market in Shares? Oliver’s Insights, 23 January 2014), While shares might see a brief 10-15% correction at some point this year, a new bear market is unlikely and as such returns should remain favourable through the year as a whole. … I have applied the definition that a cyclical bull market is a rising trend in shares that ends when shares have a 20% or more fall that takes more than 12 months to be reversed. A typical cyclical bull market since 1950 has seen shares rise 126% … and [lasts] four years. So far we are up 37% over 28 months. So history suggests more [upside of share prices] to go. Oliver elaborates: Since 2011, shares have been in a cyclical bull market, with a clear pattern of rising highs and lows. … Some factors [which Oliver specified in his article] could contrib- ute to a correction this year and at the very least more volatility in share markets. While 2010 and 2011 saw roughly 15% and 20% top to bottom falls in shares around the middle of each year, in the last two years corrections were quite mild with a roughly 10% fall around May-June in each year, so maybe we are due for a bit more volatility. … More fundamentally it’s too early in the economic-investment cycle to expect a new bear market just yet. … Rising global growth and a pick-up in Australi- an growth through the year should drive stronger profits, and optimism regarding the global economic outlook and share markets has clearly returned. But we don’t see the signs of vulnerability that become … precursors to a new bear market … Shares are no longer dirt cheap but they are not overvalued either. Price to earnings ratios are up but only to around long term average levels at 14.4 times in Australia (average is 14.1 since 1992), 15 in the US (average is 15.9 since 1992) and 14.1 for global shares (average is 16 since 1992). The gap between earnings yields and bond yields, a proxy for the excess return shares offer, remains well above pre-GFC norms. This is all reflected in our valuations indicators [i.e., the charts and graphs that accompanied Oliver’s analysis] which show markets [are presently] around fair value. … We seem a long way from the sort of investor euphoria normally seen at major market tops (see also Don Stammer, It’s Too Early to Call an End to Bull Market, The Australian, 12 November 2013 and Tom Lauricella, Is This Bull Cyclical or Secular? The Wall Street Journal, 15 June 2009). Let’s summarise Oliver’s four key assertions: 1. “since 2011 shares have been in a cyclical bull market;” 2. “while shares might see a brief 10-15% correction at some point this year, a new bear market is unlikely and as such returns should remain favourable through the year as a whole;” 3. “shares are no longer dirt cheap but they are not overvalued either;” 4. “history suggests more [upside of share prices] to go.” Page 3 of 13 Defining Some Key Terms How to assess these assertions? Is it really true that stock market indices in Australia are not pro- hibitively expensive? I don’t think so. Moreover, I also believe that weak foundations – namely imprudent assumptions and the selective use of data – underlie the bulls’ confidence. If instead we adopt cautious assumptions and analyse all relevant data, then one of Oliver’s assertions (the third) becomes highly questionable. The diametric opposite conclusion is, I believe, much closer to the truth (or at least a more sensible guideline): at present, stocks in Australia are greatly over- priced, and “investors” – “speculators” is probably a more appropriate term – who buy them at these prices will eventually regret it. In order to reason to this conclusion, rather than merely assert it, and also to understand how and why it contradicts Oliver’s, we must first define four key terms: secular bull market, secular bear market, cyclical bull market and cyclical bear market. According to Wikipedia, The terms bull market and bear market describe upward and downward market trends, respectively, and can be used to describe either the market as a whole or specific sec- tors and securities. A secular market trend is a long-term trend that lasts 5 to 25 years and consists of a series of primary trends. A secular bear market consists of smaller bull markets and larger bear markets; a secular bull market consists of larger bull markets and smaller bear markets. These basic conceptions are reasonably widely accepted.1 From them it follows that a cyclical bear market is a short-term (that is, less than five years) and downward deviation from a long-term (typically but not invariably upward) trend; similarly, cyclical bull market is a short-term and upward deviation from a long-term trend. It also follows that a cyclical bear market can occur during a secular bull market. In other words, over a given long-term (for example, ten-year) period the general trend of stock markets’ levels and investors’ returns can be upward and positive (bull market); but during that interval one or more bear markets can occur. Similarly, a cyclical bull market can occur during a secular bear market. Wikipedia elaborates: In a secular bull market the prevailing trend is “bullish” or upward-moving. The United States stock market was described as being in a secular bull market from about 1983 to 2000 (or 2007), with brief upsets including the crash of 1987 and the market collapse of 2000-2002 triggered by the dot-com bubble. In a secular bear market, the prevailing trend is “bearish,” or downward-moving.
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